Yearly Archives: 2015

Reflection

Most of you are out this week, but you’ve got phones.

Unless you’re disconnected from them like we were (by choice) a couple weeks back in the Caribbean, you’ll see this post. Send it to your CEO and CFO.

Whatever the theme for the year – “it ended flat,” “The Fed led,” “August Correction,” “Flash Boys,” “The Year of the ETF” – we’ll wrap it by pointing you to our friends at Themis Trading for a final lesson on market structure.  Read “Yale Investment Chief: America’s Equity Markets are Broken,” (if you’re not reading the Themis blog you should be) and reflect:

-The $25 billion Yale endowment fund favors private investments where horizons are longer and less liquid. Think about how often you’ve heard you need “more liquidity.”

-“Market fragmentation allows high-frequency traders and exchanges to profit at the expense of long-term investors.”

-“Market depth is an illusion that fades in the face of real buying and selling.”

-“Exchanges advance the interests of traders by sponsoring esoteric order types, which for hard-to-understand reasons receive the approval of the SEC.”

-And if you’ve not yet done so, read Flash Boys

Then read this editorial in the New York Times.

On January 6, we’ll talk about 2016.  Happy New Year!

Best Of: The Vacuum

Editorial Note: Happy Holidays! We’re back from travels but will share our findings in the first Market Structure Map of the new year. Ahead of Christmas, we’re re-running the most-read MSM of 2015. Market structure should rank among your top priorities, IR professionals. You can target investors and tell your story till your fingers are worked to bone and it won’t matter if the structure of the market sets your price. Seek first to understand. Read on (first published Dec 9): 

Looking around at the market, we decided the only thing to do is go to St. Maarten.  Safely at sea, we’ll wait out options-expirations and the Fed meeting next week and return Dec 21 to tell you what we saw from afar.

What’s up close is volatility. Monday in US equities 100 stocks were down 10% or more. And NYSE Arca, the largest marketplace for ETFs, announced that it would expand the ranges in which securities can trade following a halt.  Where previous bands were 1-5% depending on the security’s price, new rules to take effect soon double these ranges.

Energy, commodity and biotech stocks led Monday decliners and we had clients in all three sectors down double digits. Yet just 15 ETFs swooned 10% or more. How can ETFs holding the same stocks falling double digits drop less? The simplest explanation is that the ETFs do not, in fact, own the underlying stocks.

We return to these themes because they’re why markets are not rational. Your management teams, investor-relations professionals, should understand what’s made them this way.

Suppose ETFs substitute cash for securities. How does net asset value in the ETF adjust downward to reflect pressure on the indexes ETF track if the ETFs hold dollars instead?  This would seem good.  But it enriches ETF authorized participants, brokers ordained to maintain supply and demand in ETFs, who the next day will sell ETF shares and buy the underlying stocks (just 12 stocks were down double-digits yesterday).

What we hear from clients is, “The action in my shares seems irrational. I don’t understand how we could drop 15% on a 5% decline in oil.” It’s bad enough that oil dropped 5% in a day.  And lest you think your sector is immune, what’s afflicting energy could shift any time to other sectors. How? Four factors:

Arbitrage. The stock market today appears to be packed with more arbitrage – by which we mean pursuing profits in short-term divergences – than any other market in history. There’s index arbitrage, ETF arbitrage, sector arbitrage, derivatives arbitrage, multi-asset-class arbitrage, currency arbitrage, latency arbitrage, market-making arbitrage, long-short arbitrage and rebate arbitrage. A breathtaking amount of price-activity in the market can disappear the moment gaps present too great a risk for short-term traders.

Risk-transfer. There is insurance for everything, and that includes equity-exposure. Rules against risk-taking have sharply reduced the number of parties capable of providing insurance. When these big counterparties begin to experience losses, they dump assets to prevent further loss, exacerbating price-pressure. And what if they quit entirely?

Derivatives. Any instrument that substitutes for ownership is credit, and that’s what derivatives are. ETFs do it.  Options and futures do.  Swaps.  Currencies.  What things trade more than all the rest?  These.  The market is astonishingly reliant on credit.

Illiquidity.  There may be no harder-edged jargon than the word “liquidity.” It means ready supply of something. If you need it right now, can you get it, and how much, and at what cost? The stock market with $25 trillion of value is extraordinarily short on the product that this value seems to reflect, because of the three other items above.

Who’s to blame? In Bell, CA, the municipal government became profligate because the people it served stopped paying attention. The market is yours, public companies. That it’s stuffed with arbitrage is partly our fault. Companies spend millions on enterprise-resource planning software to track every detail. Yet the backbone of the balance sheet is public equity and an alarming number have no idea how it’s really priced or by what. To that end, read our IEX exchange-application letter.

The IR profession can correct this problem by leading the effort to end the information vacuum. It starts with understanding what in the world is going on out there, and it continues through insisting that management learn something about market structure.  A task: Follow the cash. When your listing exchange next reports results, read them and see how it makes money.

BEST OF: From Jan 7, 2015 – Adapting

EDITORIAL NOTE: We’re getting far away from today’s Federal Reserve decision colliding with options expirations (VIX today, with more expirations tomorrow and Friday), escaping to the elbow of the Caribbean, the divide between windward and leeward on a catamaran around St Maarten. Happy Holidays! As the year concludes, I think this view from back in January about a rising dollar and the IR job now resonates. Read on retrospectively: 

From Jan 7, 2015: Adapting

Happy New Year!  We trust you enjoyed last week’s respite from the Market Structure Map.  Now, back to reality!

CNBC is leaving Nielsen for somebody who’ll track viewer data better.  Nielsen says CNBC is off 13% from 2013. CNBC says Nielsen misses people viewing in new ways. Criticize CNBC for seeming to kill a messenger with an unpopular epistle but commend it too for innovating. Maybe Nielsen isn’t metering the right things.

I’m reminded of what we called in my youth “the cow business.” The lament then was the demise of small cattle ranches like the one on which I grew up (20,000 acres is slight by western cow-punching standards). Cowboying was a dying business.

And then ranchers changed. They learned to measure herd data and use new technologies like artificial insemination to boost output. They adapted to the American palate. Today you can’t find a gastropub without a braised short rib or a flatiron steak. On the ranch we ate short ribs when the freezer was about empty.  But you deliver the product the consumer wants.

Speaking of which, a Wall Street Journal article Monday noted the $200 billion of 2014 net inflows Vanguard saw to its passive portfolios, which pushed total assets to $3.1 trillion. By contrast, industry active funds declined $13 billion. That’s a radical swing.  The WSJ yesterday highlighted gravity-defying growth for Exchange-Traded Funds, now with $2 trillion of assets.

The investor-relations profession targets active investors. Yet the investor’s palate wants the flank steak of, say, currency-hedged ETFs (up about $24 billion in 2014) over the filet mignon of big-name stock-pickers. IR is chasing a shrinking herd.

Let’s learn from CNBC and ranchers, and adapt.  All the investing and trading activity in your stock – not just active holders – reflects how you’re viewed. You don’t have to cultivate the crop to tally its yield. Remember that old adage that you “manage what you measure?” Above-market inclusion in indexes and ETFs acknowledges your appeal to the investor’s palate, as does below-market levels of hedging. Are you leaving this luscious low data fruit hanging by ignoring it or failing to measure it? It’s yours!

You can target more investors, sure. Can you separate your company from the nearly $8 trillion of indexed assets held by Vanguard and Blackrock when that money buys or sells? Periodically. Then you’ll revert to the mean. This is a mathematical fact not much different than Eugene Fama’s theory on the cross-section of expected stock returns defining strategies at Dimensional Fund Advisors.

If you tell management that 40% of holders are low-turnover investors, you should also be telling them that last week indexes/ETFs drove 31% of volume and this week their market-share rose to 35%. The former owns shares but the latter sets price. Measuring data is far easier than repetitively pushing the targeting stone up the ridge after it rolls down. Sisyphus exhausted the notion of futility in Hellenic Corinth. Let’s learn from history.

And you know what?  Among the most valuable constituents in your equity market are speculators.  They’re not noise, they’re a sensor telling you many things investors can’t or won’t about risk and uncertainty (or event-driven behavior).  Measure them!  Own the data.  Use the data to define IR success in a way that reflects investment behavior now.

Moral of the story:  When history moves on, move with it. Tomorrow’s IR relevance rests not in doing more of the same old thing but in adapting to the world as it is (too bad the Federal Reserve and climatologists don’t learn this lesson).

Last, a word on markets:  Have you ridden a teeter-totter with somebody heavier than you?  If they slide forward and you shift back, you can balance unequal things.

Let’s tweak that analogy now. Suppose the fulcrum – the bar in the middle – moved instead, adjusting with you to stabilize imbalances. That’s the Federal Reserve. When it began buying mortgage-backed securities in January 2009, the Fed skewed the fulcrum, causing things like stocks, bonds, real estate and oil to perform much better than any of these would have if the fulcrum had remained fixed.

The fulcrum is the dollar.  It’s now moving back toward center. So far, only oil has revalued to reflect the real-world position of the fulcrum. But everything else must follow.  We’ve been saying this since September.

We think a great many do not appreciate the importance of the fulcrum – the dollar – in how everything is priced. Unless we switch to goats or camels as the medium of commerce, we should expect what mathematically follows the reversal of sustained currency-depreciation.

The Vacuum

Looking around at the market, we decided the only thing to do is go to St. Maarten.  Safely at sea, we’ll wait out options-expirations and the Fed meeting next week and return Dec 21 to tell you what we saw from afar.

What’s up close is volatility. Monday in US equities 100 stocks were down 10% or more. And NYSE Arca, the largest marketplace for ETFs, announced that it would expand the ranges in which securities can trade following a halt.  Where previous bands were 1-5% depending on the security’s price, new rules to take effect soon double these ranges.

Energy, commodity and biotech stocks led Monday decliners and we had clients in all three sectors down double digits. Yet just 15 ETFs swooned 10% or more. How can ETFs holding the same stocks falling double digits drop less? The simplest explanation is that the ETFs do not, in fact, own the underlying stocks.

We return to these themes because they’re why markets are not rational. Your management teams, investor-relations professionals, should understand what’s made them this way.

Suppose ETFs substitute cash for securities. How does net asset value in the ETF adjust downward to reflect pressure on the indexes ETF track if the ETFs hold dollars instead?  This would seem good.  But it enriches ETF authorized participants, brokers ordained to maintain supply and demand in ETFs, who the next day will sell ETF shares and buy the underlying stocks (just 12 stocks were down double-digits yesterday).

What we hear from clients is, “The action in my shares seems irrational. I don’t understand how we could drop 15% on a 5% decline in oil.” It’s bad enough that oil dropped 5% in a day.  And lest you think your sector is immune, what’s afflicting energy could shift any time to other sectors. How? Four factors:

Arbitrage. The stock market today appears to be packed with more arbitrage – by which we mean pursuing profits in short-term divergences – than any other market in history. There’s index arbitrage, ETF arbitrage, sector arbitrage, derivatives arbitrage, multi-asset-class arbitrage, currency arbitrage, latency arbitrage, market-making arbitrage, long-short arbitrage and rebate arbitrage. A breathtaking amount of price-activity in the market can disappear the moment gaps present too great a risk for short-term traders.

Risk-transfer. There is insurance for everything, and that includes equity-exposure. Rules against risk-taking have sharply reduced the number of parties capable of providing insurance. When these big counterparties begin to experience losses, they dump assets to prevent further loss, exacerbating price-pressure. And what if they quit entirely?

Derivatives. Any instrument that substitutes for ownership is credit, and that’s what derivatives are. ETFs do it.  Options and futures do.  Swaps.  Currencies.  What things trade more than all the rest?  These.  The market is astonishingly reliant on credit.

Illiquidity.  There may be no harder-edged jargon than the word “liquidity.” It means ready supply of something. If you need it right now, can you get it, and how much, and at what cost? The stock market with $25 trillion of value is extraordinarily short on the product that this value seems to reflect, because of the three other items above.

Who’s to blame? In Bell, CA, the municipal government became profligate because the people it served stopped paying attention. The market is yours, public companies. That it’s stuffed with arbitrage is partly our fault. Companies spend millions on enterprise-resource planning software to track every detail. Yet the backbone of the balance sheet is public equity and an alarming number have no idea how it’s really priced or by what. To that end, read our IEX exchange-application letter.

The IR profession can correct this problem by leading the effort to end the information vacuum. It starts with understanding what in the world is going on out there, and it continues through insisting that management learn something about market structure.  A task: Follow the cash. When your listing exchange next reports results, read them and see how it makes money.

Dollars and Sense

I looked back at what we wrote Dec 2, 2008. It was two weeks before Madoff (pronounced “made off” we’d observed bemusedly) became synonymous with fraud. Markets were approaching ramming speed into the Mar 2009 financial-crisis nadir.

In that environment on this date then, we introduced you to Ronin Capital, a Chicago proprietary trader. It had exploded through the equity data we were tracking. Today it’s a top-twenty proprietary trader in equities but not the runway model.

Yet it’s thriving. It has 350 employees. Its regulatory filings show $9.5 billion of assets including financial instruments valued at $6.4 billion, with government securities comprising $4.5 billion, derivatives about $1.1 billion, and equities about $700 million.

As the Federal Reserve contemplates a rate-increase in two weeks, Ronin Capital is a microcosm for the whole market. Its asset-mix describes what we see behaviorally in your trading, clients: Leveraged assets, dollars shifting from equity trading to derivatives, producing declining volumes and paradoxically rising prices. In a word, arbitrage.

The Fed Funds rate is the daily cost at which banks with reserves at the Fed loan them to each other.  The Fed last raised it June 29, 2006 to 5.25%, marking a pre-crisis zenith. As the housing market trembled, the Fed backpedaled to 4.25% by December 2007. On Dec 16, 2008 the Fed cut to 0.00%-0.25%, where it remains.

Since the Fed began tracking these rates following departure from the gold standard in 1971, the previous low was 1% in June 2003 as the economy was trudging up from the 9/11 swale. The high was 20% (overnight!) in May 1981.  It’s averaged about 5%.

Now for almost ten years – the life of the benchmark US Treasury – there has been no rate-increase. Since 2008, it’s been close to free for big banks to loan each other money. Backing up to Nov 30, 2006, the Fed’s balance sheet showed bank reserves at $8.9 billion, lower than (but statistically similar to) $11.2 billion at Nov 29, 1996. But at Nov 27, 2015, the Fed held $2.6 trillion of bank reserves, an increase of 29,000%.

Lest you seethe, this money was manufactured by the Fed and paid to banks that bought government debt and our mortgages.  It didn’t exist outside the Fed.

The construction of the financial instruments held by Ronin Capital describes how these polices have affected market activity.  First, the pillar of the asset base is government debt, the most abundant security in the world (a commodity – something available everywhere – cannot be the safest asset, by the way).  Governments need buyers for debt so rules manufacture a market. All the big banks hold gobs of government debt.

Second, Ronin holds equity swaps, equity options, options on futures, and currency forward contracts which collectively are 34% greater than underlying equity assets. We infer that Ronin makes money by leveraging into short-term directional trades in options and currencies. It’s worked well. It did in real estate too ten years ago, until mortgage-backed derivatives devalued as appreciation in the underlying asset, houses, stalled.

Ronin Capital, big banks, derivatives, currencies, equities and interest rates are interlaced. When money lacks inherent worth, speculation increases. Government debt is today’s real estate market underpinning massive leverage in today’s mortgage-backed securities, the sea of derivatives delivering short-term arbitrage profits.

To see the potential Fed rate increase Dec 16 as but a step toward normalization is to misunderstand the foundation of capital today. Raising rates to 0.25%-0.50% is good. But it’s at least 29,005% different from raising rates to 5.25% in 2006.

You don’t have to grasp all the mechanics, IR professionals. You do have to understand that if fundamentals have been marginalized by arbitrage the past seven years, wait till the calculus in arbitrage changes.  It’s happening already. We saw a steep drop in shorting the past two weeks. Sounds good, right? But it means borrowing is tightening.

Don’t blame Ronin Capital for adapting.  In fact, forget blame, though it’s apparent where it lies. Let’s instead think about the implication for our task in the equity market. It’s about to get a lot more interesting, and not because of fundamentals.

The good news is that it’s never been more vital to measure your market structure and report facts to management. This is when IR careers are made.

The Frontier

A war of words is unfolding in our profession.

In case you’ve not followed, it’s about the market for the product you manage as investor-relations officers. Many of you have read Flash Boys, Michael Lewis’s (The Big Short is soon coming to movie screens) engaging story of high-speed trading in equities. IEX, the upstart Lewis profiles, aims now to become a stock exchange, listing and trading your shares. Its application is up for public comment.

The dirt’s flying. IEX is accused by establishment exchanges of operating an unfair structure. The broker earned its stripes by offering investors a transparent alternative trading system characterized by the Magic Shoe Box – a fiber optic coil standardizing access to prices. You ought to read what’s been said and how IEX is responding.  We suspect its future fellows may regret having hurled recriminations. Seriously. See the comment letters from foes and friends (Southeastern Management’s supportive letter, signed by fellow investment managers in Declaration of Independence fashion, is a must-read. We’re finalizing ours now.).

Why care from the IR chair? Can your CFO explain to the Board how the company’s shares trade?  Public companies have left responsibility for the market to somebody else. The small city of Bell, CA followed this strategy and later found its managers were paying themselves a million dollars. Do you know what your exchange sells?

We’re picking no fights with the Big Two though you regular readers know we’re critical of their arbitrage incentives, how exchange revenue-drivers shift focus from investment to setting prices. When they match a baseline percentage of trades in your shares (and quote best prices often enough), then under the rules of the Consolidated Tape Association, exchanges receive the lion’s share of market-data revenues from the national system tracking prices and volumes. I think the establishment simply resists sharing with IEX a piece of this pie (how about growing the pie bigger?).

By setting prices continuously the exchanges create additional proprietary data that they sell back to traders and market centers. Why do they buy it?  Any participant serving customers must offer best prices and to ensure that they do, rules say they must buy all the data. Fee schedules for the exchanges show data-feeds can cost vast sums.

Yet in a perverse irony that cannot be blamed solely on the exchanges, traders with no customers often set most prices. These firms are the high-frequency traders about which Flash Boys unfolds its racy narrative.

IEX won’t be paying fast traders to set prices. It’s got a straightforward approach to matching customers. Read the comments on both sides and send a couple along to your executives. Ultimately the equity market exists for you, public companies, and your active investors, not so traders can arbitrage some split-second spread. We should then ask why legacy exchanges are paying for split-second prices.

We admire our friends at IEX and want them to succeed. Where companies once listed on many exchanges – Pacific, Boston, Philadelphia, Chicago, Cincinnati and other markets – the choices today are Either Or.  BATS has no current plans for listings beyond ETFs so it’s a duopoly. Our profession should welcome a fresh third option.

As the tryptophan turkey high tomorrow washes by and you give thanks (in the USA we worship turkey on the 4th Thursday of November, international readers), be glad about the ever-present opportunity for say on market structure, about which issuers are notoriously silent. Resolve to be louder.  Go forth boldly and lay claim to the frontier.

Mispricing

If the stock market reflects all information currently known, why are buyout deals nearly always done at a premium to market price?

“Because, Quast, deals involve proprietary pricing models that account for synergies.”

Sure. But I want you to think about prices. The Wall Street Journal recently reported that Blackrock cut fees on several exchange-traded funds (ETFs) to three cents per $100 of assets annually.

Low fees appeal. But how are they doing it?  After all, ETFs are notoriously high-turnover vehicles. The Investment Company Institute says conventional institutions sell about 42% of asset annually. Data from ETF Database showed ETF turnover of 2,200% annually, and leveraged ETFs using derivatives to achieve returns turning over a shocking 164 times more than underlying assets. At that rate, a $1 billion ETF could trade $164 billion of shares in a year. Tally your volume over the trailing year and divide by your average market-cap and it’s probably 1-3 times.

It’s an axiom of financial markets that churning assets consumes returns. So how can ETFs be low-cost vehicles? In June 2011, Financial Times of London writer Isabella Kiminska brilliantly observed that ETFs are built around what she termed “manufactured arbitrage.” If ETFs aren’t making money on fees it’s because they make it elsewhere.

In fact shares of ETFs represent something that exists elsewhere. Every day, ETF sponsors like Invesco and Blackrock give their brokerage agents called authorized participants (APs) a creation basket, a list of securities or other assets held by the ETF. The AP assembles this list for the ETF and receives in kind a bunch of paper – a chunk of ETF shares to sell. The AP may substitute cash for the creation basket too.

APs thus always know before everyone else whether demand is rising or falling. An AP could buy underlying securities (or borrow them) and supply them to the ETF, and then sell the ETF shares, and if the ETF is later discounted to the underlying securities, buy the ETF shares and redeem them to the ETF. The ETF industry in fact touts this continual arbitrage opportunity in ETFs as a key efficiency feature.

Actually, it explains why ETFs have low costs. There’s a lot of money in trading paper back and forth while not having to compete with anybody else.  ETFs and APs are a closed market that collectively is always a step ahead.

High-frequency traders (HFT) also claim to offer efficacy through frenzy.  Modern Markets Initiative, the HFT industry lobbying group, says HFT fuels “market efficiency” because automated markets reduce costs, enhance access and increase competition. It defies logic to propose you can reduce costs by doing more of something (politicians often make this claim, which future financial outcomes refute).

“Market efficiency” is a euphemism for arbitrage. We’ve been led to believe that because arbitrage occurs where pricing gaps form, created arbitrage will eliminate gaps. No, what goes away are real prices.

There’s yet a third instance of this pricing contradiction amid the market’s core building blocks. Reg NMS capped the fee for buying shares at $0.30 yet all three big exchanges pay sellers more than that. The NYSE pays its best trading customers about $0.34 per hundred traded shares, the Nasdaq about the same. BATS Group pays top customers in thinly traded stocks $0.45 per hundred shares to sell while charging just $0.25 per hundred to buy.  All three will pay extra to traders active in both stocks and derivatives, the latter called “Tape B” securities denoting the facility for most derivatives trades.

Why are they paying more than they charge? Arbitrage, here between the trades and the value of data. By paying traders to set prices, data become more valuable. All three sell feeds and technology to brokers and traders for sums ranging from $5,000 monthly for a cabinet in a collocation facility to $100,000 monthly for an enterprise data feed.

What drives most of the volume in markets? ETFs are behind disproportionate amounts. HFT gets paid to set prices.  And APs – the big prime brokers like Goldman Sachs and Morgan Stanley – drive half the market volume. A key motivation across the three is profiting on spreads.

These gaps aren’t occurring through information asymmetry or market inefficiencies but are manufactured through the form ETFs take as derivatives and through the fee-structure and function of the National Market System.

No wonder there’s a premium on go-private deals.  They cut out the middle men arbitraging away real prices. And no wonder it’s so difficult to match the market to reality. It’s deliberately and mechanically manufacturing prices. That’s apparent when one understands ETFs, HFT and exchange market-access fees.

The Obvious

Algorithmic trading is Wall Street’s last best hope.

So said the lead sentence in a story called Algo Wars in the May 30, 2005 edition of Investment Dealer’s Digest. That publication is gone and so is Lehman Brothers, co-leader of program-trading at the NYSE in May 2005, and computers were then rapidly displacing humans in driving it.

Algorithms, computerized mathematical models for trading, are ubiquitous now not just in equities but across a spectrum of electronically traded securities ranging from currencies and options to futures and US Treasuries.

History illuminates origins. It’s the reason to be a student of it, paraphrasing the Spanish philosopher called George Santayana (his actual name is a lot longer), who made the cover of Time Magazine in 1936 and observed that those who cannot remember the past are condemned to repeat it.

Algorithms, the article says, were birthed by “market developments and regulations that made trading equities more complicated and less profitable.” It quotes Sang Lee, founder of then brand-new market consultancy Aite Group, now a thought leader on market structure, saying algorithms “emerged from this hostile institutional trading environment where it’s getting increasingly difficult to move large blocks of orders.”

That was ten years ago. I had started ModernIR a few months earlier. Josh Friedlander, author of Algo Wars, wrote near the beginning that “because the democratization of algorithmic trading has just begun, its impact on the corporate world is still uncertain,” referring to ambiguity about how algorithms would affect stocks of companies.

Friedlander also wondered if small-caps, victimized then by decimalization and a regulatory separation of research and trading, would suffer further. The JOBS Act, made law in 2012, made it easier for small firms to go public but didn’t address structural woes for small stocks.  Today analyst coverage is a Rorschach blot on the biggest 750 firms, leaving 3,000 largely in uncovered white space. And the buyside and sellside have spent billions on technologies for hiding trades in a complex market.

Exchange Traded Funds (ETFs) grew out of this milieu. Moving big orders was a problem a decade ago.  Now look at it. We have Blackrock and Vanguard with $8 trillion of assets and a stock market with $24 trillion of capitalization. ETFs are the next evolution for a market built on rules meant to fuel movement but which paradoxically paralyze it.

I looked up one of our small-cap clients with about $1 billion of market cap and compared it to one with $10 billion. The small-cap was in 58 ETFs, 15% more than the $10 billion stock, and short volumes for it are in the highest 20% marketwide. It’s not that ETFs are focused on small-caps. Our typical large-cap client with $25 billion or more of market-cap is in about 100 ETFs.  Borrowing and derivatives predominate.

What should be obvious from the IR chair upon retrospection is how little faith one can have in what’s observable on the surface of price and volume.  ETFs move positions relentlessly and without respect to news save for reactions to prices and direction where applicable. Algorithms proliferating for a decade are designed to hide intention.

If as an institutional seller you wanted to obscure your disbursements, would you employ algorithms that pressured prices?  Selling would be patently obvious and the billions spent on sleights of hand wasted.  Clients, you know we routinely observe contrarian patterns in the data – Positive sentiment signaling impending pressure, Negative sentiment a bottom and probable buying.

Let me summarize. The obvious lesson of history here is that a decade of profound stock-market transformation coupled with leviathan investment from its core participants in purpose-obfuscating trading technologies will not produce a market where you look at your price and volume and say, “I think we have a big seller.”

Every now and then that might be right. But 90% of the time what seems to be apparent is probably not what’s occurring.  Thus ModernIR thrives today and we can help anybody regardless of size or trading volume observe reality under the market’s skin.

Stein’s Law

Why are stocks rising if earnings and revenues are falling?

FactSet’s latest Earnings Insight with 70% of the S&P 500 reporting says earnings are down 2.2% versus the third quarter last year, revenues off 2.9%.  Yardeni Reseach Inc. shows a massive stock-disconnect with global growth. Yet since the swale in August marked a correction (10% decline), stocks have recouped that and more.

We’re not market prognosticators. But the core differentiation in our worldview from an analytical standpoint is that we see the stock market the way Google views you:  possessing discrete and measurable demographics. When you search for something online you see what you sought served up via ads at Google, Facebook, Twitter, etc. Advertising algorithms can track your movement and respond to it. They don’t consider you just another human doing exactly the same things as everybody else.

If your stock rises because your peer reports good results, your conclusion shouldn’t stop at “we’re up thanks to them,” but should continue on to “what behavior reacted to their results and what does it say about expectations for us?” Assuming that investors are responsible for the move requires supposing all market behavior is equal, which it is not.

I saw a Market Expectation yesterday for one of our clients reporting today before the open predicting a higher price but not on investor-enthusiasm. Fast traders were 45% of their volume, active and passive investors a combined 40%. So bull bets by speculators trumped weak expectations from investors.  Bets thus will drive outcomes today.

Which leads back to the market. We separate monetary behaviors into distinct groups with different measurable motivation. By correlating behavioral changes we can see what sets prices. For instance, high correlation between what we call Risk Management – the use of derivatives including options and futures – and Active Investment is a hallmark of hedge-fund behavior. The combination dominated October markets. And before the rebound swung into high gear, we saw colossal Risk Management – rights to stocks.

What led markets higher in October are the very things that led it lower Aug-Sep. The top three sectors in October: Basic Materials, Technology, Energy.  Look at three representative ETFs for these groups and graph them over six months: XLB, XLK, XLE.

We might define arbitrage as a buy low, sell high strategy involving two or more securities. The data imply arbitrage involving derivatives and equities. Sell the derivatives, buy the stocks, buy the derivatives, exercise the derivatives.

That chain of events will magnify recovery because it forces counterparties like Deutsche Bank (cutting 35,000 jobs, exiting ten countries), Credit Suisse (raising capital), Morgan Stanley (weak trading results), Goldman Sachs (underperformance in trading) and JP Morgan (underperformance in trading) among others to cover derivatives.

And since the market is interconnected today through indexes and ETFs, an isolated rising tide lifts all boats.  A stock that’s in technology ETFs may also be in broad-market baskets including Russell, midcap, growth, S&P 500, MSCI and other indices.  As these stocks, rise, broad measures do.

At October 22, the ModernIR 10-point Behavioral Index (we call it MIRBI) was topped, signaling impending retreat. That day, the European Central Bank de facto devalued the Euro. The next day, the Chinese Central Bank did the same.  The Federal Reserve followed suit October 28 by holding rates steady. Stocks suddenly accelerated and haven’t slowed. The MIRBI never fell to neutral and is now nearing a back-to-back top.

You’ll recall that Herb Stein, father of famous Ben, coined Stein’s Law: “If something cannot last forever, it will stop.” The rally in stocks has been led by things that cannot last. In fact, the conditions fueling equity gains – everywhere, not just in the US – are comprised of what tends to have a short shelf life (options expire the week after next). Bear markets historically are typified by a steep retreat, followed by a sharp recovery, followed by a long decline.

Whatever the state of the market, what’s occurring won’t last because we can see that arbitrage disconnected from fundamental facts drove it. Understanding what behavior sets prices is the most important aspect of market structure. And it’s the beginning point for great IR.

Your Voice

I debated high-frequency trader Remco Lenterman on market structure for two hours.

Legendary financial writer Kate Welling (longtime Barron’s managing editor) moderated.  Your executives should be reading Kate so propose to your CFO or CEO that you get a subscription to wellingonwallstreet.com. The blow-by-blow with Remco is called Mano-a-Mano but the reason to read is Kate’s timely financial reporting.

Speaking of market structure, yesterday the SEC’s Equity Market Structure Advisory Committee (EMSAC…makes one think of a giant room-sized flashing and whirring machine) met on matters like high-frequency trading and exchange-traded funds.

Public companies have a friend or two there (IEX’s Brad Katsuyama, folks from Invesco and T Rowe Price) but no emissaries. Suppose we were starting a country to be of, for, and by the people but the cadre creating it weren’t letting the people vote?

It makes one think the party convening the committee (the SEC) can’t handle the truth.  After all, it was the person heading that body, Mary Jo White, who proclaimed in May that the equity market exists for investors and issuers and their interests must be paramount.  It’s a funny way to show it.

And now the NYSE and the Nasdaq, left off too, are protesting. BATS is on while listing only ETFs. The Nasdaq generates most of its revenue from data and technology services, not listings.  Intercontinental Exchange, parent of the NYSE, yesterday bought Interactive Data Corp, a giant data vendor, for $5.6 billion.

How long have we been saying the exchanges are in the data and technology businesses? They’re shareholder-owned entities that understand market structure and how to make money under its rules. That’s not bad but it means they’re not your advocates (yet you get the majority of your IR tools through them, which should give you pause).

On CNBC yesterday morning the Squawk Box crew was talking about one of our clients whose revenues near $2 billion were a million dollars – to the third decimal point in effect – shy of estimates. Droves of sellsiders have shifted to the IR chair, suggesting diminishing impact from equity research and yet that stock moved 8% intraday between high and low prices.

What long-term investor cares if a company’s revenues are $2.983 billion or $2.984 billion (numbers massaged for anonymity)? So how can it be rational?

I hear it now:  “It’s not the number but the trend.”  “It’s the color.”  “Revenues weren’t the issue but the guidance was.”

You’re making the point for me. IR professionals have vast and detailed knowledge of our fundamentals as public companies, as we should.  We know each nuance in the numbers, as we should.  We understand the particulate minutia of variances in flux analysis. As we should.

But we don’t get the mechanics of how shares are bought and sold, or by whom. We don’t know how many can be consumed without moving price.  We trust somehow the stock market works and it’s somebody else’s responsibility to ensure that it does.

Ask yourselves:  Would we trust our sales and revenues to a black box? Then why do we trust our balance sheets – underpinned by equity – to one?

Read my debate with Remco Lenterman about what constitutes liquidity and what sets price today (throw in with the c-suite on a subscription to wellingonwallstreet.com).

We picked two of scores of reporting clients this week and checked tick data at the open. Prices for both were set by one traded share.  Suppose you’re the CEO with a stake worth $300 million. We’ve got one of those reporting tomorrow.  What if the first trade is for one share, valued at say $80, and it shaves 8% off market-cap? That’s $24 million lost in that moment, on paper, for your CEO on a trade for $80.

Now you can say, “You’re caught up in the microsecond, Quast. You need to think long-term.”

Or you could wonder, “Why is that possible?  And is it good for long-term money?”

It’s easier for a camel to pass through the eye of a needle than for rational investors to price a stock at the open in today’s market structure.  But we have the power to change that condition by demanding to be part of the conversation. It starts with caring about market structure – because you don’t want the CEO coming back to you later asking, “Why didn’t you tell me?”

Somebody from among us must be on that SEC committee, whirring lights and all.